To Russia With Love
Both Mobile TeleSystems and VimpelCom offer investors 2012 upside.
One quarter into 2012, Russia has been far and away the most impressive stock market on the grid. A mix of surging oil prices, rising wage growth, lower inflation, and a strengthening ruble has set the stage for one of the healthiest consumer environments the country has seen in years. The two major publicly traded telecom carriers, Mobile TeleSystems (MBT) and VimpelCom (VIP), performed handily in the first quarter. As we begin to see margins stabilize and capital expenditures level off, free cash flow could increase at a faster-than-expected rate. This, combined with the prospects of a second-half interest rate cut in Russia, low smartphone penetration rates, and 5% dividend yields, means share price outperformance could be sustainable.
Russia's stock market performance underscores an impressive economic rebound that's been supported by improving real wage growth and inflation levels hovering around 20-year lows. This has produced a surge in disposable income, which has spurred a revival in wireless subscriber growth despite astronomically high penetration rates (157% at the end of December). In fact, all aspects of the consumer sector seem to be improving, as retail sales jumped 7.7% year over year in February, easily besting expectations. The economic upswing has been buoyed by a 37% increase in oil prices over the past six months. The oil price strength is a combination of stronger global GDP growth assumptions (now that fears of a complete European collapse have been quelled) and Iran-Israel conflict premiums. Regardless of commodity prices, President-elect Vladimir Putin remains adamant about raising salaries, and with unemployment still far lower than normal (6.5% in February) and the prospects for second-half rate cuts, the stage is set for consumer-based industries such as telecom to flourish.
First-Quarter Global Stock Market Performance
Source: Morningstar Investment Research
Competitive and Regulatory Landscapes Also Improving
While MegaFon has been able to steal subscribers from Mobile TeleSystems over the past couple of years, we believe the sector has now reached its comfort zone in terms of share distribution. With churn rates rising across the board and margins in decline, we are already seeing the major operators becoming more rational. Ultimately, the big three players in the oligopoly seem resigned to split 85% of the market, with Tele2 and Rostelecom having to work from their leftovers. Thus, it seems pointless for the three major players to prioritize subscriber share over economic efficiency and profit optimization. There are still no subsidies in the mobile market--due largely to the absence of a ubiquitous credit check system--which has slowed the proliferation of top-tier smartphone devices like the iPhone. Smartphone sales only represent roughly one fourth of new sales, versus more than 50% in the United States. This means there is still upside in average revenue per user to be had, and with capital expenditures easing as the firms finish up their 3G network deployments, the sector's outlook for free cash flow is bright. We believe both Mobile TeleSystems and VimpelCom offer investors a compelling investment profile for 2012.
Mobile TeleSystems' new management team has refocused its strategy around higher-value subscribers, which has helped its average revenue per user rebound to 2009 levels. The better subscriber mix, combined with stronger data traffic and record high voice usage, has helped stabilize the firm's margins, which had been eroding over the past few years. In 2011, management's new focus began to bear fruit. We believe the recent margin improvements are sustainable, given the transition to revenue-sharing models for dealer commissions, the introduction of more sensible tariff plans, and the increased centralization of procurement through infrastructure-sharing agreements and outsourcing of network maintenance. All of this should flow down to the bottom line and make the firm more economically efficient.
With its shareholder dispute with Telenor resolved and the wheels being put in motion for a sale of Algerian unit Djezzy, VimpelCom now seems ready to shift its strategic focus back to its home base of Russia. While the merger with Wind radically diversified its operational footprint, Russia--which contributes roughly 40% of the group's revenue and EBITDA--is still by far the firm's most important market. The firm was able to regain market share in 2011 after a couple years of decline. Now that its share has stabilized, we expect management to focus on improving gross margins by stimulating on-net traffic and optimizing the product portfolio. Prices were down nearly 15% year over year in the fourth quarter, but the firm now seems prepared to downshift its level of intensity. We also expect to see the focus shift to reducing the cost of goods sold by restructuring the dealer commissions along the lines of what we are seeing from Mobile TeleSystems. The firm needs to work on improving its quarterly churn rate (now at a record-high 17%) by creating new customer loyalty programs.
On the regulatory front, things have been very quiet. There was talk of cuts to mobile termination rates and international roaming charges, but nothing materialized. We'll be keeping an eye out for the framework of the 4G spectrum auction that we expect to take place in the second half of the year. Assuming four spectrum blocks will be up for sale, it's likely we'll see the three major carriers making purchases, with the last block going to either Rostelecom or Tele2. It's possible Tele2 will try to refarm its current 2G spectrum for LTE, so odds are Rostelecom, which has strong mobile ambitions, will snag the last license.
More Upside Left in the Tank
While SIM card sales and churn increases will continue to pressure sector margins, we project the trends to go from negative to stable. With the changes in dealer commission framework, more rational promotional strategies, and a plateau in capital expenditures, free cash flow for the sector should rise. MegaFon, and its level of competitive intensity, is the key X factor; if it puts its foot back on the gas, Mobile TeleSystems and VimpelCom would mount a competitive response. Still, we believe in 2012 the carriers have already begun to make the strategic shift from share gains to operational efficiency. Combining the increased rationality with a healthier economic backdrop, surging oil prices, a strengthening ruble, and a secular growth vehicle such as smartphones, we believe Mobile TeleSystems and VimpelCom will outperform the market in 2012.
Imari Love does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.